BAFI3200 International Finance

Topic 9: International Portfolio Investment

Lesson Objectives

• Understand the international correlation structure and risk

diversification
• Evaluate optimal international portfolio selection decision
• Analyse the effects of changes in the exchange rate
• Identify international bond investment
• Identify international diversification at home
• Explain home bias in portfolio holdings
Introduction

• Rapid growth in international portfolio investments in recent years reflects

the globalization of financial markets
• In this chapter, we focus on the following issues:
o Why investors diversify their portfolios internationally
o How much investors can gain from international diversification
o Effects of fluctuating exchange rates on international portfolio
investments
o How investors can diversify internationally at home
o Possible reasons for “home bias” in actual portfolio holdings
U.S. Investment in Foreign Equities
International Correlation Structure and Risk Diversification

• Investors can reduce portfolio risk by holding securities that are less than
perfectly correlated
• International diversification has a special dimension regarding portfolio
risk diversification
• Security returns are substantially less correlated across countries than
within a country
o This is true because economic, political, institutional, and even
psychological factors affecting security returns tend to vary a great
deal across countries
o Business cycles are often high asynchronous across countries
Correlations among International Stock Returns
International Correlation Structure and Risk Diversification
(Continued)

• Solnik (1974) study shows that as a portfolio holds more and more stocks,
the risk of the portfolio steadily declines, and eventually converges to the
systematic (or nondiversifiable) risk
o Systematic risk refers to the risk that remains even after investors fully
diversify their portfolio holdings
o Results of this study (shown on graphs in the next slide) provide
striking evidence supporting international, as opposed to purely
domestic, diversification
Risk Reduction: Domestic versus International Diversification
Cautionary Notes about International Correlation

1. A number of studies found that correlations between international stock

markets, especially developed markets, have increased
o These correlations are computed at the aggregate stock market level,
not the individual stock level; securities are still less correlated across
countries than within a country
2. Empirical studies found that international stock markets tend to move more
closely together when the market volatility is higher
o Unless investors liquidate their portfolio holdings during the turbulent
period, they can still benefit from international risk diversification
Average Return Correlation, 1980-2018
Optimal International Portfolio Selection

• Rational investors would select portfolios by considering returns as well as risk

o World beta measures the sensitivity of a national market to world market

movements, with a higher number indicating greater sensitivity to world market
movements

• Sharpe performance measure (SHP) provides a risk-adjusted performance measure

o i and σi are respectively, the mean and standard deviation of returns, while Rf is the
risk-free interest rate
Optimal International Portfolio Selection (Continued)

• The optimal international portfolio (OIP) has the highest possible

Sharpe ratio
o The OIP can be solved by maximizing the Sharpe ratio with respect to
the portfolio weights
o SHP = [E(Rp) − Rf]/σp
• After obtaining OIPs, we can measure gains from holding these portfolios
over purely domestic ones in two ways:
1. Increase in the Sharpe performance measure
2. Increase in the portfolio return at the domestic-equivalent risk level
Composition of the Optimal International Portfolio by
Investor’s Domicile, 1980.1 – 2018.12
Selection of the Optimal International Portfolio for U.S.
Investors
Effects of Changes in the Exchange Rate

• The realized dollar return for a U.S. resident investing in a foreign market will
depend not only on the return in the foreign market but also on the change in
the exchange rate between the U.S. dollar and the foreign currency
• Rate of return in dollar terms from investing in the ith foreign market, Ri$, is
given by:

where Ri is the local currency rate of return from the ith foreign market and ei is
the rate of change in the exchange rate between the local currency and the
dollar
Effects of Changes in the Exchange Rate (Continued)

• Exchange rate changes affect the risk of foreign investment as follows, where the
ΔVar term represents the contribution of the cross-product term, Riei, to the risk of
foreign investment

• Exchange rate fluctuations contribute to the risk of foreign investment through three
possible channels:
1. Its own volatility, Var(ei)

2. Its covariance with the local market returns, Cov(Ri,ei)

3. Contribution of the cross-product term, ΔVar
International Bond Investment

• World bond market is comparable in terms of capitalization value to the

world stock market, but it has not received as much attention in international
investment literature
o Existing studies show that when investors control exchange risk by using
currency forward contracts, they can substantially enhance the efficiency
of international bond portfolios
o The advent of the euro altered the risk-return characteristics of the euro-
zone bond markets, enhancing the importance of non-euro currency
bonds
Summary Statistics of the Monthly Returns to Bonds and the
Composition of the Optimal International Bond Portfolio
International Diversification: Mutual Funds

• Purchasing foreign stocks directly from foreign exchanges can entail significant transaction
costs
• Other modes of international diversification are less cumbersome:
o U.S.-based international mutual funds invest in securities from countries other than
the U.S.
o Advantages of international mutual funds:
• Investors can save any extra transaction and/or information costs they may have
to incur when they attempt to invest directly in foreign markets
• Circumvent many legal/institutional barriers to direct portfolio investments in
foreign markets
• Benefit from the expertise of professional fund managers
International Diversification: Country Funds

• A country fund invests exclusively in stocks of a single country

• Popular means of international investment in the U.S., as well as in other
developed countries
• Using country funds, investors can
1. Speculate in a single foreign market with minimum costs
2. Construct their own personal international portfolios using country
funds as building blocks
3. Diversify into emerging markets that are otherwise practically
inaccessible
International Diversification: ETFs

• In the last several years, there has been a broad shift from actively
managed mutual funds to passive investment vehicles
• An exchange-traded fund (ETF) is an investment vehicle that seeks to
track the performance of a specific index, typically an equity index
o ETFs are highly liquid, and it is easy to buy and sell them
o Most ETFs are passive, though some active ETFs exist
o A family of ETFs called iShares (managed by BlackRock) has the
broadest range of country ETFs with 65 funds across 42 countries
International Diversification: ADRs

• American depository receipts (ADRs) represent receipts for foreign shares

held in the U.S. (depository) banks’ foreign branches or custodians
o ADRs are traded on U.S. exchanges like domestic American securities
o Because the majority of ADRs are from such developed countries as
Australia, Japan, and the U.K., U.S. investors have a limited
opportunity to diversify into emerging markets using ADRs
• However, in a few emerging markets like Mexico, investors can
choose from several ADRs.
International Diversification: Hedge Funds

• Hedge funds that represent privately pooled investment funds have

experienced a tremendous growth in recent years
o May invest in a wide spectrum of securities, such as currencies,
domestic and foreign bonds and stocks, commodities, real estate, etc.
o Many aim to realize positive returns, regardless of market conditions
o Legally, hedge funds are private investment partnerships
o Tend to have relatively low correlations with various stock market
benchmarks and thus allow investors to diversify their portfolio risk
International Diversification with Industry, Style, and
Factor Portfolios

• Investors can enhance the gains from international investment by augmenting their
portfolios with industry, small-cap, or factor funds
o Studies document greater diversification benefits from investing across not just
countries, but also industries
o International diversification can be further enhanced by employing factor and style
investing
• Style investing refers to categorizing assets into different styles based on
common characteristics (e.g., large-cap and value stocks)
• Three factors—size, book-to-market, and momentum—have been widely used in
asset pricing models to explain stock returns
Home Bias in Portfolio Holdings

• In portfolio holdings, the tendency of an investor to hold a larger portion of the home
country securities than is optimum for diversification of risk is home bias
o Though investors could benefit a great deal from international diversification, the
actual portfolios that investors hold are quite different from those predicted by the
theory of international portfolio investment
• U.S. mutual funds, for instance, invested about 87% of their funds in domestic
equities on average during 1998–2007, when the U.S. stock market only
accounted for about 45% of the world market capitalization value during the
period
The Home Bias in Equity Portfolios: Selected Countries,
1998 - 2007
Why Home Bias in Portfolio Holdings?

• Observed home bias in portfolio holdings leads to the following

possibilities:
1. Domestic securities may provide investors with certain extra services,
such as hedging against domestic inflation, that foreign securities do
not
2. There may be barriers, formal or informal, to investing in foreign
securities that keep investors from realizing gains from international
diversification
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